CRYPTOCURRENCY REGULATIONS: INSTITUTIONS AND FINANCIAL OPENNESS

1. INTRODUCTION
Cryptocurrency is currently at the frontier of financial development. It provides both
opportunities and risks in financial markets and has attracted significant attention in
recent years. Accordingly, the number of market players involved in the cryptocurrency
business has risen (Farell 2015). The new business model provided by cryptocurrency
along with the exponential increases in the prices of cryptocurrency may have
enticed investors toward cryptocurrency, with many utilizing cryptocurrencies as a
speculative asset to take advantage of the early gains. However, the subsequent
crash in prices acted as a wake-up call to speculators dealing with cryptocurrency.
Additionally, risks related to price manipulation in cryptocurrency markets are not
unheard of (Gandal et al. 2018).
Although many central banks issue warnings about the use of cryptocurrency and have
explicitly denied its status as a currency, only a few have banned its use as a financial
asset. Policy makers are concerned about the low liquidity, the use of leverage, market
risks from volatility, and the operational risks of cryptocurrency (FSB 2018). Many central
banks emphasize that cryptocurrency is not legal tender and that users face the risk of
unenforceability of cryptocurrency transactions. The Global Research Center (2018)
compiled regulations on cryptocurrency and its report shows that, in countries where
cryptocurrency is allowed, it can be legally traded as long as it follows existing rules or
laws related to financial instruments. Regardless of the regulatory stance, policy makers
are wary that cryptocurrency would be used for illegal activities, such as money
laundering, trade in illegal or controlled substances, or terrorism finance. Policy makers
are also aware of the potential lack of consumer and investor protection. Deposit
insurance for holders of cryptocurrency is limited and not supplied by
domestic monetary authorities. The combination of its potential benefits as well as
macroeconomic risks begs the question of what determines policy openness or aversion
to cryptocurrency.
Research on cryptocurrency encompasses several fields of study, from economics and
finance to computer science and engineering, as well as applied mathematics. The
breadth of the research field is not surprising given the nature of cryptocurrency as a
financial innovation with its roots in blockchain technology and the fact that it uses
cryptography intensively. Farell (2015) provides a brief historical background to
cryptocurrency and discusses the security networks used by major cryptocurrency
providers and the implications for the cryptocurrency industry. DeVries (2016) presents
an examination of the bitcoin market and industry players using a SWOT (Strengths,
Weaknesses, Opportunities, and Threats) framework, which is a common management
analysis tool. Recent economic literature on cryptocurrency delves into issues such as
determinants of cryptocurrency prices (Liu and Tsyvinski 2018; Corbet, Lucey, and
Yarovaya 2018), cryptocurrency exchange rates (Li and Wang 2017), and persistence in
the cryptocurrency market (Caporale, Gil-Alana, and Plastun 2019; Bouri et al. 2019),
among other things. To date, there are no studies specifically investigating the factors
influencing the policy stance on cryptocurrency.
In this study, we examine whether the presence or absence of credible surveillance and
regulatory authorities influences the extent to which policy makers would allow, regulate,
or take a hands-off approach to cryptocurrency. This study contributes to literature by
bringing together two strands of literature—one examining cryptocurrency regulation and
the other investigating financial development through legal institutions and financial
openness. On the one hand, the need to balance promoting innovation while mitigating
economic risks has sparked interest in the appropriate legal and regulatory framework 

surrounding cryptocurrency. Marian (2015) proposes a regulatory system that imposes
costs on anonymity to curtail potential illicit uses of cryptocurrency, such as tax evasion,
money laundering, or financing terrorism, without disincentivizing the innovation that
cryptocurrency could bring. On the other hand, previous research has provided evidence
linking the quality of institutions and governance effectiveness to financial development
(La Porta et al. 1998; Beck, Demirgüç-Kunt, and Levine 2001; Nee and Opper 2009).
Furthermore, several research works have delved into the relationship between
increased financial openness through capital account liberalization and financial
development. A recent research by Ozkok (2015) shows that financial openness, along
with other institutional variables, explains a large proportion of the variations in financial
development across countries and over time. Meanwhile, Klein and Olivei (2008) show
that the link between capital mobility and financial depth is significant in countries with
high levels of institutional quality, i.e. industrialized countries. While regulation of
cryptocurrency, a decentralized asset, is difficult, its potential destabilizing effects on
vulnerable financial markets emphasize the need for vigilance in cryptocurrency market
development.
To provide an empirical examination of the policy stance toward cryptocurrency,
we begin by composing an index of de jure openness to cryptocurrency using the current
legal and regulatory status of cryptocurrency compiled in 2018 by the Global Legal
Research Center, the Bitcoin Market Journal, and CoinStaker. We identify three broad
types of regulation system in 218 economies—fully liberalized, regulated, and banned.
The policy choice of allowing the use, regulating, or prohibiting the use of cryptocurrency
can represent, on the one hand, how open policy makers are to new avenues in financial
development or, on the other, how prudent they are in adopting new financial technology.
Then, we refer to Chinn and Ito (2006) as our baseline model to investigate empirically
whether both institutional quality and a higher level of financial openness are associated
with a less restrictive policy stance toward cryptocurrency. We use a cross-sectional
ordered probit model and regress the de jure index of cryptocurrency, on the one hand,
and a well-developed policy environment and de jure capital openness on the other.
Then, we control variables representing institutional and macroeconomic factors that can
affect cryptocurrency regulation. The analysis is based on data covering 124 economies.
Our results show that a well-functioning policy environment is associated with a
greater likelihood of a less restrictive regulatory stance on cryptocurrency. Meanwhile,
financial openness is not found to be significant. Our results are robust to alternate
specifications, testing the sensitivity of the results to alternate measures of policy
environment, and also the choice of year in the data used for the econometric estimation.
The paper is structured as follows. Section 2 provides a brief overview of what
cryptocurrency is and its current legal and policy environment. Section 3 discusses the
links between financial development, on the one hand, and financial openness and legal
systems, on the other, as well as their implications for the policy stance on
cryptocurrency. Section 4 presents our econometric model, describes the data, and
provides descriptive statistics of the variables. In addition, we also explain our index of
de jure openness to cryptocurrency (cc) in detail on the data source and the method of
compilation and classification. Section 5 provides empirical results, discussion, and
policy implications, particularly for emerging Asian economies. Robustness checks are
also provided in this section. Section 6 concludes.

CRYPTOCURRENCY REGULATIONS: INSTITUTIONS AND FINANCIAL OPENNESS